Financial engineers have a new playground: ETFs

By Agnes T. CraneThe author is a Reuters Breakingviews columnist. The opinions expressed are her own.

It didn’t take long for financial engineers to find a new playground. Fresh from dreaming up collateralized debt obligations (CDOs), structured finance specialists are applying the same techniques to exchange-traded funds. ETFs are wildly popular with big and small investors who love the liquidity and diversification such investments promise. But derivatives, special purpose vehicles and skewed incentives — hallmarks of the last boom — have found their way into ETFs as well.

The Financial Stability Board and the International Monetary Fund sounded the alarm this week, warning that ETF innovations could pose a threat to financial stability. In an eerie echo of what many said about CDOs and other complex financial products last decade, the regulators noted that no one really knows how these ETFs will stand up when markets next freak out.

ETFs that use derivatives to mimic the performance of an underlying index are worthy of particular scrutiny. The FSB notes that, in these structures, incentives may be skewed. As a synthetic ETF involves both the bank’s asset management arm and its swaps desk, the bank can benefit twice. Additionally, synthetic ETFs can give banks a cheap source of funding for difficult-to-trade securities. But that could be a potential disaster if ETF investors suddenly want their money back.

Moreover, synthetic ETFs bring back the bogeyman of the 2008 financial meltdown — counterparty risk. Synthetic ETFs, which make up nearly half of Europe’s $275 billion market, expose investors to the fortunes of the bank, not just the ups and downs of the market.

Then there is securities lending. This is a profitable side business for some ETF providers, who lend the collateral backing their investment vehicles to other investors for a fee. This is all well and good, until there’s a spike in redemptions and providers need their collateral back in a hurry.

At $1.5 trillion and climbing, the global ETF market is here to stay. Yet the onus should be on banks to prove their new toys aren’t simply hiding risk behind a complex web of arcane, yet fragile, financial innovations. If they can’t do that, it’s better to keep ETFs confined to their simplest form.